In the past few weeks, we observed a meaningful sell-off in Chinese property high yield bonds, with yields now averaging 8.3% for the sector. This is around 187bps higher than the beginning of the year and 224bps higher since the end of 2016. Chinese property stocks, on the other hand, have risen 9.2% year-to-date and have returned 245% since the end of 2016. This is not the first time that bond and equity performance diverged, but this deviation is significant, and we think Chinese property high yield bond valuation is attractive.
Chinese developers have significantly improved their operations over the past few years. USD bond issuers saw their sales increase by 146% and their equity market capitalization rise by 166% on average. Their credit fundamentals have been stable to improving over the past three years and we believe many developers’ ability to withstand industry volatility has improved materially. Larger developers have demonstrated a good track record of tapping various funding channels (bonds, loans, equity, convertible bonds, etc.), and have repaid their bonds on a timely basis. The sector is maturing and investors have generally gotten more comfortable investing in this segment.
Back in 2010, the top 50 developers’ market share was less than 20%. However, market concentration has increased significantly over the past two years with the top 10 developers capturing 24% market share by 2017. Higher land prices, better access to funding and industry economies of scale have contributed to this substantial increase in market share of the larger developers. We expect this trend to further accelerate in the next 2-3 years, particularly when the onshore funding becomes tighter for the sector. We expect consolidation and further divergence between large and small players going forward, with the strong getting stronger and the weak eventually exiting the industry.
We think the recent correction in bond prices is more driven by technical factors than fundamentals. Back in 2016/early 2017, most developers opted to issue onshore bonds due to cheaper financing costs relative to issuing offshore and USD issuance quotas imposed by regulators. The resulting low supply of USD bonds relative to demand caused yields to hit record low levels. However, this year the situation reversed – credit conditions in the onshore market became relatively tighter while regulators expanded quotas for offshore bond issuance. This led many developers to issue USD bonds as they refinanced their debt and the sudden increase in new issuance caused some indigestion in the system, driving spreads wider. We believe this is a temporary phenomenon and expect valuations to stabilize when offshore issuances return to more normal levels. More recently, we observed some recent onshore bond deals priced at yields comparable or even wider than offshore levels, though with smaller deal sizes. We anticipate developers will seek to balance their funding sources and financing costs between both channels, as they seek to avoid being overly reliant on the offshore market, regardless of pricing.
It is important for developers to have strong track records, solid market positions (preferably top 50 in China) and prudent management. We also analyze companies’ land reserves and look for developers that have well-diversified exposure to economically strong cities and reasonable margins based on current selling prices. For developers that fit these criteria, we seek attractive yields relative to fundamentals that offer a good yield cushion to weather the rate hike cycle.